FOUNDATIONS OF MICRO-BANKING THEORY

1. FOUNDATIONS OF MICRO-BANKING THEORY • CHAPTER 2: Why do financial intermediaries exist? • CHAPTER 3: The Industrial Organisation approach to Banking • CHAPTER 4: The Lender-Borrower Relationship

2. CHAPTER 5: The equilibrium and rationing in the credit market • CHAPTER 6:Macroeconomic consequences of financial imperfections

3. CHAPTER 7: Bank runs and systemic risk • CHAPTER 8: Risk management • CHAPTER 9: Regulation

4. CHAPTER 1 Why do financial intermediaries exist? • The Classical theory • First generation • Second generation

5. Preliminary: • What is a financial intermediary? • -Deposits • - Loans • - Contracts (cannot be resold • (not anonymous • (not necessarily standard

6. What is the difference with mutual funds?

7. 1.1 The Classical theory • 1.1.1 A transaction cost approach (Benston and Smith, 1976) • Institutions emerge because they allow to diminish contracting costs: • 1) costs of becoming informed • 2) costs of structuring, administering and enforcing financial contracts • 3) cost of transferring financial claims

8. 1.1 The Classical theory (continued) • 1.1.2Transformation of assets (Gurley and Show, 1960) • maturity • convenience of denomination • risk (indivisibilities) (Merton, 1989) • It is implicitly assumed that these asset transformation services are provided more efficiently outside the firm.

9. Implications • economies of scale • economies of scope • reputational capital • reduction in search costs

10. 1.1 The Classical theory (end) • 1.1.3Payment system (Fama, 1980)

11. 1.2 First Generation • The delegated monitoring approach (Diamond 1984) • Diamond-Dybvig: Liquidity insurance Ex ante uncertainty defines the liquidity shock

12. Diamond-Dybvig model: one good three period economy. Continuum of consumer-depositors, each endowed with one unit of the goodRandom preferences (not VNM)

13. Consumers • U(C1) Early diers or impatient consumers • U(C2) Late diers (patient consumers)Ct is consumption at time 1 or 2 and U is increasing and concave.

14. Technology • Long run technology • t=o t=1 t=2 • -1 - R (R>1) • Storage technology • t=o t=1 • -1 1

15. Efficient solution: ex ante insurance against preferences shocks with C< R if relative risk aversion is larger than 1.

16. Market solution: early diers consume 1 late diers consume R which is not ex ante efficient • Financial intermediation A FI may provide deposits which entail a larger consumption for early diers and lower consumption for late diers thus reaching the efficient allocation.

17. Intertemporal Smooting  • An extension (Allen and Gale, 1997) • The focus is on intertemporal smoothing. • Some generations face a large return, others a smaller one. Since each generation lives only two periods, it cannot enter an explicit insurance contract. Banking provides this type of insurance and is ex ante Pareto efficient. • Ex ante uncertainty defines the liquidity shock

18. 1.3 Second generation: • Co-existence of financial intermediaries and financial markets • Agents differ by • their history of repayments • their collateral • their rating • Their information

19. Additional motivation: • Schumpeter, Gerschenkron • External finance premium • US-UK vs. Japan-Germany financial structures (Short term vs. long term)

20. 1.3.1 Diamond (1991): Monitoring and reputation • Consider a population of firms that have investment projects of three different non-observable types: • 1)high risk, high return and negative net present value • 2)low risk low return and positive net present value projects. • 3)strategic firms which are able to choose their type between the two previous ones.

21. The main issue is the moral hazard problem for the strategic firms • The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay. • MAIN RESULT:good history firms will issue securities.

22. 1.3.2Holmstrom and Tirole (1995) (Monitoring and collateral) • Moral hazard on the project choice: • The entrepreneur chooses the probability of success • The project with a lower probability of success has private benefits B for the entrepreneur.

23. The bank is able to monitor the choice of projects by diminishing B to b. • If the firm brings in sufficient collateral, or a sufficient stake in the project no monitoring is needed. • Otherwise monitoring is needed.

24. What gives the banks an incentive to monitor? • Their stake in the project (differs from rating agencies) • What makes bank loans costly? • The supply of loans is limited by the bank’s capital.

25. 1.3.3 Boot and Thakor • With some probability firms have access only to a good project and with the complementary probability they are strategic. Firms are heterogeneous as they differ in this probability • The banks’ role is to force the firms to choose the good project • The financial market helps the firms to make the right investment by signalling (via prices) the overall environment the firms face.

26. 1.3.4Bolton-Freixas (2000) • Banks are able to monitor and to renegotiate firms in financial distress • Bond holders will always liquidate firms that default. • The financial market imperfection stems from adverse selection (Myers Majluf)

27. Firms differ by their riskiness • Bank loans are at a premium • Result: risky firm prefer bank loans, safe firms prefer bonds • Consistent with empirical evidence regarding the effect of monetary policy on small firms

28. 1.3.4 Gorton-Pennacchi (1990) • Informed insiders • Some agents have priviledged information • Consumers have Diamond-Dybvig preferences • The design of securities is endogenous • Then in equilibrium there is a riskless security which can be interpreted as a bank.

29. TO SUMMARIZE • There is no a unique view • Apart from the transaction costs • Intertemporal insurance, screening and monitoring are the main reasons why financial intermediatiaris may emerge . • Consider a population of firms that have investment projects of three different non-observable types: • )high risk, high return and negative net present value • )low risk low return and positive net present value projects. • )strategic firms which are able to choose their type between the two previous ones. • The difference between banks and markets is that banks monitor strategic firms while bond markets do not. Still, there is a monitoring cost banks have to pay.